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separate-entity financial statements

Case 7-3

LO1, 2

On January 1, Year 4, Plum purchased 100% of the common shares of Slum. On December 31, Year 5,Slum purchased a machine for $168,000 from an external supplier. The machine had an estimated useful life of six years with no residual value. On December 31, Year 7, Plum purchased the machine from Slum for $200,000. The estimated remaining life at the time of the intercompany sale was four years. Plum pays income tax at the rate of 40%, whereas Slum is taxed at a rate of 30%.

When preparing the consolidated statements for Year 8, the controller and manager of accounting at Plum got into a heated debate as to the proper tax rate to use when eliminating the tax on the excess depreciation being taken by Plum. The controller thought that Slum’s tax rate should be used since Slum was the owner of this machine before the intercompany sale. The manager of accounting thought that Plum’s tax rate should be used since Plum was the actual company saving the tax at the rate of 40%.

In Year 9, the Canada Revenue Agency (CRA) audited Plum. It questioned the legitimacy of the intercompany transaction for the following reasons:

1.

Was the selling price of $200,000 a fair reflection of market value?

2.

Was Plum trying to gain a tax advantage by saving tax at a rate of 40% rather than the 30% saving that Slum used to realize?

Plum argued that, under the terms of the sale, CRA was better off because it received tax in Year 7 from the gain on the intercompany sale. Had the intercompany sale not occurred, it would not have received this tax.

Required

(a)

Determine the economic benefits, if any, to the consolidated entity from tax savings as a result of this intercompany transaction. Was it a good financial decision to undertake this transaction? Explain.

(b)

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Would your answer to (a) be any different if Plum owned only 60% of the common shares of Slum? Explain.

(c)

Indicate what amount of tax savings related to depreciation expense would be reflected on the consolidated income statement under the alternatives suggested by the controller and manager, or other options you could suggest. Which method would you recommend? Explain your answer using basic accounting principles.

(a) The following amounts would be reported on the separate-entity financial statements:

Slum’s books Plum’s books

Years 4 + 5 Years 6 through 9

Amortization per year 168,000 / 6 = 28,000 200,000 / 4 = 50,000

Tax Rate 30% 40%

Tax savings per year 8,400 20,000

Gain on Sale at end of Year 5

Proceeds on sale 200,000

Carrying amount (168,000 x 4/6) 112,000

Gain on sale 88,000

Income tax (@30%) 26,400

The consolidated entity paid taxes of $26,400 at the end of Year 5 and gained a tax saving of $20,000 – $8,400 = $11,600 per year in Years 6 through 9. In nominal terms, it gained $11,600 x 4 – $26,400 = $20,000. In present value terms, it realized a return of nearly 30%. Therefore, the intercompany sale was a good financial decision.

(b) 40% of Slum’s after-tax gain on the sale of the machine would now be credited to the non-controlling interest i.e., ($88,000 – $26,400) x 40% = $24,640. Since this amount is greater than the overall tax saving of $20,000, Plum would realize an overall loss of $4,640 on the intercompany transaction. From Plum’s perspective, it is not a good financial decision.

(c) As a result of the intercompany transaction, amortization expense has increased from $28,000 to $50,000 per year. The extra $22,000 must be eliminated on consolidation so that only $28,000 of amortization expense is reported on the consolidated income statement. Income tax on the $22,000 must also be eliminated. Three alternatives are presented below for the elimination of tax on the excess amortization for each of Years 6 to 9:

Controller Manager Other

Excess amortization $22,000 $22,000 $22,000

Proposed tax rate 30% 40% 52.727%

Tax saving eliminated 6,600 8,800 11,600

Tax saving before adjustment 20,000 20,000 20,000

Tax saving after adjustment 13,400 11,600 8,400

The controller’s suggestion of 30% can be supported on the basis that the total tax eliminated over 4 years will be $26,400 which is equal to the tax paid by Slum when the gain was reported for tax purposes. This results in reporting a tax saving of $13,400 on amortization expense of $28,000 on the consolidated income statement. This is $5,000 per year more than Slum’s tax saving of $8,400 per year before it sold the machine to Plum. This fairly presents the actual situation because Plum is achieving an incremental tax benefit of $5,000 per year (i.e. $20,000 overall gain spread over 4 years) as a result of the intercompany transaction.

The other option can initially be supported on the basis that it would report a tax saving of $8,400 on amortization expense of $28,000 on the consolidated income statement which is consistent with what was reported before the intercompany transaction occurred. However, it would eliminate a total of $46,400 of tax over 4 years, which is $20,000 more than the tax paid on the original sale of the machine. Therefore, this alternative does not fairly present the true tax situation for the consolidated entity or the non-controlling interest. The manager’s suggestion would produce similar results as the other option.